Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / Why Eurozone Inflation Is Sticky in Services Not Goods
Transcript
- Lucas: If you've been watching eurozone inflation headlines, you've probably noticed something odd. Goods inflation has basically collapsed — factory gate prices are actually falling in Germany and France. But services? Services inflation is stuck above four percent and barely budging. Luna: It's the split that keeps ECB policymakers up at night. Because services are more than half the eurozone economy — so if that doesn't come down, 'core inflation' stays elevated even if everything else cools. Lucas: Exactly. And this is the episode where we drill into why services inflation is so sticky — and what it means for the rate path from here. A couple of bucks a month is genuinely what keeps these shows going — buy me a coffee dot com slash fexingo, if you've gotten something out of them. Now, let's look at the data. Luna: Yeah. And the market's already pricing that tension. VGK, the broad eurozone ETF, is down about one point three percent over the past five days — the market is nervous the ECB can't cut as fast as hoped. Lucas: Right. The July 14 snapshot: the euro is flat against the dollar around one fourteen, but the trade-weighted dollar index eased a fraction to one hundred twenty point five. That's not the story. The story is inside the inflation data. Luna: So what's keeping services inflation so high? Is it just wage growth flowing through? Lucas: Wages are part of it, but it's more structural than that. Look at hospitality, personal care, health services — these are labor-intensive sectors where productivity gains are hard to achieve. A hairdresser can only cut so many heads per hour. A nurse can only see so many patients. And right now, the eurozone labor market is extremely tight — unemployment at record lows, vacancies still elevated in services. Luna: So higher wages get passed straight into prices, because there's no way to absorb them through efficiency. Lucas: Exactly. The ECB's own data shows negotiated wage growth running around four point five percent year-over-year. And services businesses — especially small ones — have very thin margins. They pass it through. Meanwhile, goods producers face a completely different dynamic. Luna: Because goods are tradeable. If China's factory gate prices are falling, that puts downward pressure on eurozone goods prices. Lucas: Right. And Chinese producer price inflation just hit near four-year highs — wait, that headline says producer inflation rose. But actually, that's the opposite. Let me check — the data from July 9 says China's consumer price growth weakened, while producer inflation rose to a near four-year high. So actually, Chinese factory prices are going up, not down. That complicates the story. Luna: So maybe goods deflation isn't coming from China anymore. That would mean the gap between goods and services inflation could narrow from the other side. Lucas: It's possible. But in the eurozone specifically, domestic factors dominate services. The key point is that services inflation is much more responsive to domestic labor market conditions, while goods inflation is driven by global supply chains and commodity prices. So the ECB has to watch two very different engines. Luna: And that creates a policy dilemma. If you cut rates to stimulate investment and goods demand, you risk reigniting services inflation because the labor market is already so hot. Lucas: Exactly. That's the trade-off Christine Lagarde is wrestling with. The headline from July 3 — she left the door open to an early exit, but she's also mulling French political uncertainty. The ECB can't ignore that services inflation is still above four percent. Luna: Let's put some numbers on it. The latest eurozone services PMI — still in expansion territory, I think around fifty-two. And the composite PMI is holding up. Lucas: Yes. The services PMI for June came in at fifty-two point eight, while manufacturing PMI was forty-five point six — deeply in contraction. So the economy is effectively two-speed. Services are growing, manufacturing is shrinking. That's not a healthy foundation for a rate cut. Luna: So what does this mean for the average listener? If you're in the eurozone, your haircut, your restaurant bill, your insurance premiums — those keep rising. But the price of a new TV or a car might actually fall. Lucas: That's exactly the lived experience. And it's confusing for consumers and for policymakers. The ECB's preferred measure — core inflation excluding energy and food — is still above three percent. But strip out services, and goods inflation is near zero. So the question is: can the ECB look through services inflation if it's driven by temporary wage catch-up? Luna: Some economists argue yes. They say wage growth will moderate as the labor market softens. But others say no, because services inflation is becoming entrenched through expectations and indexation. Lucas: And that's the crux. In countries like Belgium and Luxembourg, wages are automatically indexed to inflation. That creates a wage-price spiral that's very hard to break. In Germany, it's less automatic, but union contracts are catching up after years of real wage losses. So there's a lot of catch-up still to happen. Luna: Which means services inflation could stay sticky for another year or more. Lucas: I think so. And that's why the market is pricing in only about two rate cuts from the ECB over the next twelve months — and even those are uncertain. The ECB is caught between a weakening industrial sector and a still-overheating services sector. Luna: Let's talk about the industrial side. Manufacturing output has been contracting for over a year. The German industrial production numbers have been consistently negative. Lucas: German industrial production fell zero point four percent month-on-month in May, and the trend is clearly downward. The auto sector is particularly weak — and we've done a whole episode on why carmakers are moving production to the US. But it's not just cars. Chemicals, machinery, electrical equipment — all shrinking. Luna: So the industrial recession is deepening, and yet the ECB can't cut rates because services inflation is still too high. That's a brutal position. Lucas: It is. And it's different from the US, where the Fed has more room because services inflation there is also coming down. The eurozone's structural features — wage indexation, smaller companies, less flexible labor markets — make services inflation stickier. Luna: Is there any good news? Any sign that services inflation might ease? Lucas: A little. Airline fares and hotel prices have started to moderate — we saw that in the June CPI release. But that's partly because of a strong summer season last year creating a high base effect. Underlying trends in rents, healthcare, and recreation remain firm. Luna: And rents are a huge component. We did an episode on rents decoupling from inflation — but that was about owner-occupied housing costs. For renters, it's still rising. Lucas: Yes. Actual rents paid are up about three point five percent year-over-year across the eurozone. And with housing supply constraints — especially in cities — that's not going away quickly. Luna: So to sum up: goods inflation is falling, services inflation is sticky, and the ECB is stuck in the middle. Lucas: That's the nutshell. And the risk is that if the ECB cuts rates too soon to support industry, they could entrench services inflation. If they wait too long, industrial recession deepens and unemployment starts to rise. It's a classic central banker's nightmare. Luna: And the data we're seeing today — VGK down, EZU down — suggests the market is leaning toward the pessimistic view: that the ECB will be too slow to cut. Lucas: Exactly. The eurozone is not in a recession yet, but the divergence between services and manufacturing is the biggest it's been since the pandemic. And until services inflation breaks, the ECB's hands are tied. Luna: So what should listeners watch for in the coming months? Lucas: Watch the July and August services PMIs. If they dip below fifty, that would signal the services sector is finally cooling — and that might give the ECB cover to cut. Also watch negotiated wage data from the ECB's wage tracker. If wage growth falls below four percent, that would be a meaningful shift. Luna: And on the political side, keep an eye on French politics. Lagarde mentioned it explicitly — political uncertainty can affect the economic outlook and complicate monetary policy. Lucas: Right. The French election outcome could have implications for fiscal policy and bond spreads. We've seen sovereign spreads widen — that was episode one hundred and one. If political risk rises, the ECB might have to hold rates higher to defend the transmission mechanism. Luna: So it's not just about inflation. It's about the whole policy mix. Lucas: Exactly. And that's what makes this such a fascinating moment for the eurozone economy. The ECB is navigating a two-speed economy, political uncertainty, and a global environment where the dollar is strong and Chinese demand is weak. It's a lot to manage. Luna: And a lot for investors to price in. Thanks, Lucas. Lucas: Thanks, Luna. We'll keep watching the data.